What the heck is reasonable compensation anyway?

You might not be familiar with term “reasonable compensation” just yet. But come April 10 -- if not sooner -- you will be.

Why so? That’s when the Labor Department’s conflict-of-interest rule goes into effect. It’s the day when financial professionals who provide advice about the investments and insurance inside your IRA and 401(k) have to start acting in your best interest, as a fiduciary.

What’s more, it’s also the day when advisers can only charge reasonable fees or earn reasonable commissions when managing your retirement account.

Here’s the exact wording for the Labor Department’s fact sheet:

Going forward, those that provide investment advice to plans, plan sponsors, fiduciaries, plan participants, beneficiaries and IRAs and IRA owners must either avoid payments that create conflicts of interest or comply with the protective terms of an exemption issued by the Department. Under new exemptions adopted with the rule, firms will be obligated to acknowledge their status and the status of their individual advisers as "fiduciaries." Firms and advisers will be required to make prudent investment recommendations without regard to their own interests, or the interests of those other than the customer; charge only reasonable compensation (emphasis added); and make no misrepresentations to their customers regarding recommended investments. Together, the rule and exemptions impose basic standards of professional conduct that are intended to address an annual loss of billions of dollars to ordinary retirement investors as a result of conflicted advice.

So what is reasonable compensation? Well, there’s no clear-cut definition but many are searching for the holy grail. “Reasonable may ultimately be market-driven supply and demand once transparency is achieved,” says John Kilroy, a partner with iValue Financial Planning.

And Fred Reish, a partner at Drinker Biddle & Reath, had this to say: “Reasonable compensation is what a transparent and competitive marketplace would pay for the particular set of services. For example, if an adviser monitors the investment, that would worth more continuing compensation that where an adviser doesn't provide that valuable ongoing service.”

What’s more, he said the compensation must be reasonable, level, and in some cases “neutral.”

Consider also what the Insured Retirement Institute (IRI) is telling advisers, many of whom who fear litigation if they don’t comply with the Labor Department’s new rule, about the definition:

“’Reasonable compensation’ is a vague and undefined standard, but the (Labor Department) has held fiduciaries to ERISA plans to this standard for many years. Under the (Labor Department’s) rule, to the extent you are relying on the (Best Interest Contract or BIC) exemption, PTE 84-24 or other prohibited transaction exemptions, this standard will now have to be applied in the IRA market as well.”

The IRI goes on to note that advisers to IRA account owners have never before had a legal obligation to follow ERISA’s ‘reasonable compensation’ standard so this will be an adjustment for that part of the industry.”

So, how does the IRI defined reasonable compensation? “’Reasonable compensation’ has traditionally been interpreted and applied by the Labor Department as a market-based standard,” the IRI wrote in an FAQ about the subject.

And, that means, at least according to the IRI, “that compliance with this standard will be determined based on whether your (the adviser’s) compensation is line with amounts being received by others in the market in connection with recommendations of similar products, as well as the services, rights, and benefits you and your firm provide to your clients.”

The IRI notes that this “standard does not dictate any specific amount of compensation you (the adviser) and your firm can receive, but it can be expected to target at least true outliers (compensation that is far out of line with the market).

And that means, according to the IRI, that the “reasonableness of (the adviser’s) compensation will depend on the particular facts and circumstances at the time of the recommendation.”

What’s more, the IRI notes that “each firm will make its own decision about the meaning of ‘reasonable compensation’ and the policies and procedures needed to satisfy this standard.”

Put another way. Reasonable compensation is likely to be a moving target, and one that evolves over time as investors learn what they can expect to pay for investments and insurance given their facts and circumstances.

Today, what you pay for investments and insurance in your retirement accounts may or may not be reasonable. You really don’t know.

But come April, you will. Fees will be disclosed. Commissions will be standardized and disclosed. And the world of investing will look a bit more like the world of car buying, where a sticker is attached to a car window that details all costs and charges associated with the purchase, upfront in black and white.

But how advisers will get compensated as fiduciaries under the Labor Department’s rule is not necessarily a black-and-white issue. “It depends on the adviser's services and the products,” said Reish. “For advisers who provide non-discretionary investment advice for a level fee, and don't receive any payments or financial benefits from products or providers, the only impact will be on rollovers, IRA transfers and changes from commission accounts to fee accounts.”

But, advisers who recommend and sell mutual funds for a commission and trails, the changes will be significant, he said. “For example, their compensation will need to be level across all mutual funds; it cannot vary regardless of which fund they recommend or what the fund pays the broker-dealer,” said Reish. “And the compensation must be based on the services provided, instead of being primarily based on the product sold.”

To be sure, this won’t look pretty at first. We’ve got lots to sort out. For instance, there will be times when you might have to sign a BIC. That’s a contract that, in effect, says an adviser can charge you a commission to buy (and/or sell) investments and insurance for your retirement account and that you agree it’s in your best interest. When might you have to sign a BIC? We’ll tackle that in my next column on the subject. Read To roll or not: That will be the question come April 2017.

There’s also some concern that your relationship with your adviser will change because of the rule. “Hopefully the relationship trust will grow, or a client may learn something surprising or uncomfortable about the relationship,” says Kilroy. “As long as the form of compensation meets the best interest standard I would expect it to be allowed.”

Investors should also expect changes, as is already happening, to the financial services industry in the months to come. Merrill Lynch, for instance, last week announced it will no longer offer – effective April – clients the ability to open a commission-based IRA and that it plans to encourage clients in commission-based IRAs to switch into a fee-based account; State Farm and Edward Jones plan to stop selling certain investments and insurance to IRA account owners; and LPL is standardizing the commissions it charges on the sale of mutual funds and other investments. “They will learn there is truly no free lunch, and that may be an eye opener for some,” said Kilroy.

Despite all that chaos, Kilroy said there’s at least one good thing that will come of the Labor Department’s rule, as it as it pertains to reasonable compensation: transparency and accountability.

Robert Powell is editor of Retirement Weekly, published by MarketWatch. Get a 30-day free trial to Retirement Weekly. Follow Bob’s tweets at RJPIII. Got questions about retirement? Get answers. Send Bob an email here.

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